What Are Futures?
A futures contract is an agreement between two parties to buy or sell an asset at a future date at a specific price. Breaking it down, one party agrees to buy a particular commodity at a specific price at a later date, while a second party “counterparty” agrees to sell the exact commodity purchased at the agreed price and at the agreed date.
In a futures contract, price is the only variable. They are standardized for quantity, quality, and delivery specifications. Because of this, futures contracts can be traded on an exchange.
This open auction market, often consisting of hundreds or thousands of participants, brings a large amount of liquidity to futures trading. In essence, the open auction process means that you can buy from any market participant, or sell to anyone looking to buy.
It’s important to note that some commodities–such as Crude Oil, Wheat, gold, among others–are physically deliverable while other contracts (such as index futures) can only be converted into cash equivalents.
Advantage Over Stocks
Whereas the price of a stock may be driven by the estimation of future earnings, the talent of corporate management, or the quality of products produced, futures prices are driven strictly by supply and demand. The aggregate belief of the market participants determines the supply/demand balance for each commodity.
This has an advantage over stocks in that there can be no manipulation of earnings or cover-ups of the material facts. The value of a gold contract, for example, depends on what market participants believe the price of gold will be when the contract expires.
If you believe the price of gold will be higher, you would buy the contract. If you believe it will be lower, you would sell it short. Being able to short sell is an opportunity to make money when a market declines, and sometimes markets fall faster than they rise!